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Cost-Cutter Or Recipe For Conflict?

Written by Cinthia Murphy and Olly Ludwig

 –  September 26, 2012

[This article was originally published on our sister website, IndexUniverse.com]

Self-indexing in the ETF industry is hardly a new phenomenon. In fact, some US ETF providers—WisdomTree and IndexIQ, to name two—have successfully built entire business models that rely solely on in-house index creation.

But until recently self-indexing had been largely confined to niche strategies, and that’s a state of affairs that will no longer continue if iShares, the world’s biggest ETF company, jumps into the self-indexing game.

In the summer of 2011, BlackRock—iShares’ parent company—filed paperwork with U.S. regulators seeking permission to provide the underlying benchmarks for its exchange-traded funds. iShares offers a vast roster of funds that tap into just about every segment of the market.

Having iShares possibly join the likes of WisdomTree and IndexIQ as companies that create indices for their own funds would certainly shake up the status quo for big and influential index providers such as S&P Dow Jones Indices, MSCI, Russell and FTSE, to name a few.

“No one had a beef with WisdomTree and IndexIQ,” said Kathleen Moriarty, an attorney with Katten Muchin Rosenman LLP in New York who had a hand in writing some of the early self-indexing petitions submitted to the Securities and Exchange Commission. “These were firms that believed in their own indices and wanted to create products around them,” Moriarty said.

“What interests me is that it seems like people are all of a sudden flipping out, and I think it’s because BlackRock is deciding to do self-indexing. BlackRock was not in the index game originally, so it has a different profile than the original two firms,” Moriarty said.

BlackRock’s plans to develop its own benchmarks has indeed triggered a wave of controversy, with some saying that the do-it-yourself approach to indexing ETFs does nothing but open the door to conflicts of interest and mismanagement, even if investors benefit from potentially lower costs.

Controversy notwithstanding, a series of interviews IndexUniverse did with industry heavyweights pointed to one conclusion: whether self-indexing is a good trend for investors is really in the eyes of the beholder.

Devil’s In The Details

For one, companies like WisdomTree and IndexIQ have successfully dodged much of criticism directed at the self-indexing movement because what they serve up is anything but plain-vanilla.

In other words, they’re not reinventing the S&P 500, and nor do they want to.

In fact, one head of a self-indexing firm went as far as to say that if he were ever to launch an S&P 500-like fund, he would be giving S&P Dow Jones Indices a call.

Instead, the strategies these firms have put into ETF wrappers are arguably far enough off the beaten path to make in-house index methodology creation and management a necessity. That’s because third-party index providers might not be prepared to meet these companies’ needs, so one argument goes.

“For us, it’s really all about quality control and oversight of our products,” Adam Patti, the chief executive officer of Rye Brook, NY-based IndexIQ said in a telephone interview.

In IndexIQ’s case, the company creates the methodology, runs the models, but delegates the actual index calculation to a third party, or S&P Dow Jones.

That delegation of calculation is something that goes unnoticed by many, S&P Dow Jones Indices’ Alex Matturri said. Indeed, the giant index provider has many layers of offerings, some of which include calculating indices that don’t carry the S&P Dow name brand, as is the case for IndexIQ benchmarks.

“The decision to self-index is less related to cost, but more related to quality control,” Patti said. “It’s very costly to build your own research team and maintain an index unit.” he said, arguing that unless an ETF issuer has enough scale to absorb those costs, it makes no sense to self-index.



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